Congress Puts SBA Venture Capital Program On Hold

The Small Business Investment Company [SBIC] program was reauthorized, but SBA officials will continue to focus on limiting the government's exposure to losses from this venture capital program. The White House estimates bad investments by SBICs could cost taxpayers $2 billion. Says [SBA Associate Administrator Anthony] Bedell, "We need to stop that bleeding."

By 'partial' I mean that existing, qualified SBIC funds can continue to draw against their authorized loans, but new licenses will not be issued.

For those not in the VC game, let me back up and explain the program. SBIC status allows smaller venture capital funds to augment the money they have raised from limited partners with a federal loan, usually at a 2x multiple. This obviously increases the amount of money that can be put to work, the number or size of deals that can be accommodated, and naturally the management fees that can be collected. The loan money is the first dollar repaid as liquidity events occur, but the effective interest rate (floating around 8%) is not at all bad for money at this risk level.

(Our fund is not an SBIC. The program includes governance requirements - no overseas managing partners, for instance - that did not fit our situation, plus the lead time and paperwork of the program were also a disincentive. We decided to stay small and unleveraged. The latter has made my sleep better through the worst of the bubble bust.)

The effect of the program is to provide an extra helping of relatively cheap capital at the earlier stage of ventures, which fits the SBA's overall charter to promote small and new American businesses. And the SBA is really not all that bad a lending parter, paperwork aside, given their alignment of strategic interest with the overall venture capital goals. Historically, the program has been profitable, and been an object of bipartisan support at renewal time. Jobs, profits, what's not to like?

There is the little matter of that $2 billion current loss, however. What happened? I don't have the detailed numbers, but it's not hard to guess. During the late '90s, a lot of first time funds were launched and gained apparent success based on the rising dot-com tide that lifted all valuations. This gave their managers the necessary chops to obtain an SBIC license and leverage up for their second funds, which were put into the market at the peak of the bubble, from late 1998 into mid-2000. Come the dot-com and communications busts, many of the invested companies from these second funds went belly up or were forced into severe down rounds.

Tough enough for a non-SBIC fund. But a loan is leverage, no matter how accommodating the lender, and it's a painful thing when you're underwater. The SBIC terms do include 'impairment' clauses, triggered by falling valuations of the portfolio. Among other things, these clauses can trigger the immediate call of all the remaining committed capital from the regular limited partners. A limited - particularly the individuals who got into smaller funds - staring at a near wipeout of his already paid in capital will be sorely tempted to try and walk away from this further obligation. There have been stories (which I won't source) floating around for some time of funds that imploded in exactly that fashion. Also rumors of strange and wonderful tactics employed to avoid a down valuation event that would trigger an impairment, though any rational transaction would do precisely that. Such tricks run out after a while. Bottom line: If the SBA is losing that much money, there are a lot of limiteds in SBIC funds who have been wiped out.

I'm personally ambivalent about the program. As mentioned, it does have the effect of amplifying the capital pool for earlier stage ventures, meaning more starts and more innovation and jobs. On the other hand, there's a lot of discussion that the overall pool of private capital for venture is perhaps still oversupplied with respect to the number of quality startups available and their capital needs. Too much money in early stages can simply mean higher valuations that make it hard for the investor to show a profit downstream, and funding of marginal early stage companies which fail to find support in their later rounds. The program also has a mild compensating effect for the offshoring movement in high tech, due to its requirements for locating a majority of jobs created in the US.

While I could go either way, it's worth making one observation about the actions of the Congress and SBA: They are in danger of falling into the 'corporate fund' investor profile. It's somewhat of an adage in this game that corporates always come into venture near a peak, bail out when the market heads South, and never get back in at the botton when they could recoup losses. (Exceptions to this dish are made for those, such as Intel Capital, that have shown the intestinal fortitude to stay in through multiple business cycles.) The same can be said of many individual investors, whether acting as 'angels' or as limited partners in funds. Such countercyclic behavior not only costs money, but makes them suspect partners over the long haul. The SBA has just taken the first step in that direction.